Does this little scenario sound familiar to you: You are following one of your favorite forex pairs. A nice trend is forming of higher highs and higher lows. You decide the time is right to ride this trend and make it your friend. You buy in at 1.25, just below support and place a Stop Loss order just below that to protect your downside. Then you wait for the action to start rising northward. Unfortunately, Mr. Market has other ideas. It hobbles along for bit, and then takes a dive of around 30 pips, just enough to stop you out, and then – you know what happens next – it blasts back up through 1.25 and beyond.
After a few expletives directed at your computer screen, the world at large, and especially at your broker, you begin to calm down. You know that you have been trained to accept what the market gives you, put your emotions aside, and then look for the next opportunity. But, being stopped out before a big run up has a way of ripping at your gut. As forex or stock or whatever trader you have chosen to be, we have all had this happen to us not once, but several times. Veterans, however, know what is truly going on behind the scenes, stopped complaining about it long ago, and actually developed a trading strategy to take advantage of this “dreaded” market behavior, called “stop hunting”.
What are the real causes of stop hunting?
If you are prone to blaming someone else for being stopped out, then the likely target for your screams of derision would more than likely be your broker. How could he do this to me again and again? The fact is that he could get into hot water big time with the regulators and with his customer base if he deliberately posted lower prices before a run up. Price manipulation is not taken lightly by the powers that be. They have complaint follow-up procedures and monitoring services that sound alerts for this type of thing. Yes, you may have seen spreads widen, but there are valid reasons for that, too.
The “culprit”, if we need to use that label, is your hedge fund or big institutional trader that needs to place a large position, many multiples greater than your order, to take advantage of the same trend that you spotted. His major issue, however, is liquidity. If he tries to enter the market with a large order, he knows that the market will bust north, which will cost him dearly. He knows that stop orders are lurking just below support, so he sells first, a moderately sized order that will tend to jerk the market down a bit. He knows that he can then scoop up the stop orders and save a bundle.
But what about the spreads, you ask? The broker is surely in on the “scheme”, isn’t he? Actually, he is not. He is keeping a close eye on the futures market, the forum where he hedges his risk and part of what being a “market maker” is all about. Before key events and even at times when ranging occurs around support or resistance, market participants will withdraw their Buy/Sell orders, thereby withdrawing their liquidity at the same time. Your broker has no choice but to widen his spreads to protect himself. He is taking his guidance from the spreads he can obtain in the futures market. Of course, if he has a habit of acting unethically in your opinion, then you can file a complaint. There are shady brokers out there, but it is not widespread. It may be time for a change.
How do you prevent being stopped out before a big breakout?
If you do have the fear of being stopped out, or “FOBSO” to coin a phrase, then you do have options. If you had been confident that the bottom would not fall out of the market in the above example, then you might not use a Stop Loss order at all. This option, however, is regarded as pure heresy in some circles. You are inviting instant doom, if you go this route. The preferred option is to set a Stop Loss order beyond what would be expected for the situation at hand.
Many traders routinely set Stop Losses at 15 to 25 pips below their entry point. Veterans and smart money folks know this and count on it when applying their various strategies. Choose a wider gap next time, one more tied to the Average True Range indicator. If you manage the size of your positions in line with your Stop Loss, then you might want to consider reducing it a bit, too. The objective is to be safely outside the range of a potential quick down move, such that you win on the way up and achieve a higher reward ratio, as well. Set your “Take Profit” position accordingly.
What kind of trading strategy can be built around stop hunting?
There is one more option, but it has nothing to do with the above scenario. Veterans have learned to see the activity above as a potential “Trade Setup” and have designed an aggressive strategy to take advantage of Stop Hunting scenarios. As a single retail forex trader, we will never be able to chase after Stop Loss orders like the big players in the market. What we can do is notice when the situation is ripe for stop hunting and then prepare to take advantage of the swift jerk up in valuations.
Using the scenario above, you wanted to go long and protect yourself, right around a support level. Here is where patience is a necessity. Watch the candlesticks forming around support. If they move below support, then wait to see if a major price rejection occurs, i.e., the place where stop hunting commences. Go long on the next candle, with stop loss protection. Be sure to cheer when the market goes north. This strategy also works well in a shorting situation by taking the opposite path.
Are you suffering from “FOBSO”? Do you want to fire your broker? Playing the blame game can be fun, but it will not help you become a better trader. You can avoid the pain by widening your Stop Loss order, when you see this type of Trade Setup forming, but you may still lose, if the downdraft is excessive. Otherwise, you can take the offensive. Prepare to trade the jerk back reaction and ride the wave that you wanted to do in the first place. You may still have to place a Stop Loss order, but in this strategy, you will be more concerned about when to take your profit.
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